JPY taking advantage of USD weakness and sentiment change

[MongiIG]

The US dollar has been underperforming amid concerns about inflation.

Daniela Sabin Hathorn | Presenter and Analyst, London | Publication date: Friday 29 July 2022 

USD underperforming

The US dollar has been the clear outperformer in the second quarter (Q2) as concerns about inflation were at their highest.

One of the currencies against which it clearly outperformed was the Japanese yen, and a rate differential trade started to unfold.

The Bank of Japan’s (BoJ) unwillingness to tighten monetary policy – in part because they didn’t need to – was a stark contrast to the Federal Reserve’s (Fed) guidance, which was getting more and more hawkish as the days went by. A carry trade involves borrowing at a lower-interest rate and investing in a higher one, which in USD/JPY meant borrowing in yen and investing in dollars.

In trading terms, the transaction isn’t as technical, but people were buying into USD/JPY because of the Fed’s positioning versus that of the BoJ.

Economies under pressure

But the tides are turning, and inflation is no longer at the forefront of concerns. The last few weeks have proved that economies are under pressure and market participants are taking note. Whilst the Japanese yen hasn’t been a good hedge against soaring inflation, it is seen as a safe haven against economic hardship.

The latest economic data in the US is also putting upward pressure on bonds, bringing yields down alongside the US dollar. The Fed’s warning on Wednesday about potentially slowing the pace of rate hikes given the significant drop in consumer spending was also a blow for the dollar.

And, not only has sentiment changed but we also have USD/JPY trading at 20-year highs. This leaves some good room for a corrective retracement even before we start to consider a change in momentum. That said, the pair has now dropped below its ascending channel that has been in play since the beginning of the year, so the bullish drive is slightly diminishing.

Fundamentally, the argument remains very much in favour of bullish USD/JPY given that US rates are expected to continue higher, whilst Japanese rates will remain unchanged.

But once US rates start to slow and even turn downwards once again, then USD/JPY is definitely a good pair to watch out for. For now, though, it’s looking like short-term trading momentum is firming to the downside, so following the trend may be a good way to go.

The pair is approaching a key area of support around 132.40 which may come into contact in the next few days. If we continue to see sellers halted around this area it confirms the longer-term bullish trend is still intact, but a further follow-through to the downside and we could see some USD buyers starting to be kicked out of the market.